Comment Letter On Our Crime Scene Of A Stock Market
Still wondering why the US (and global) stock market is nothing more than a crime scene, and an imminent catastrophe waiting to happen, supervised and regulated by a bunch of "special" porn addicts? Then read the following comment letter and wonder no more.
Subject: File No. S7-02-10
From: R T Leuchtkafer
File No. 265–26 and Release 34-61358 File No. S7-02-10
On a cloudy autumn afternoon in 1870, the Chicago White Stockings, a
team that would evolve into the present day hapless Chicago Cubs, played
an exhibition baseball game against a hastily assembled gang of
amateurs calling itself the Board of Trade Scalpers. It was a rout. In
nine innings of play at Dexter Park, next door to Chicago's new
stockyards, the White Stockings crushed the Scalpers by a score of 30 to
2, likely the only time scalpers on the Chicago futures exchanges were
so convincingly restrained.
140 years later, almost to the day, U.S. Commodity Futures Trading
Commission Chief Economist Andrei Kirilenko and several co-authors
published a paper called "The Flash Crash: The Impact of High Frequency
Trading on an Electronic Market," to date the definitive examination of
high frequency market makers. What Kirilenko reported is deeply
troubling for U.S. markets, implying structural instability, crashes and
liquidity crises large and small, toxic quotes and price discovery in
the public markets, and the uncertainty of any order's likely effect on
prices. His breakthrough paper is a decisive empirical justification for
reforming how high frequency market makers operate in today's markets.
Though he doesn't use the word, Kirilenko's study is the latest U.S.
government agency report on scalpers. Perhaps the earliest was by the
Federal Trade Commission (FTC) in a seven volume report on grain
trading, published over six years beginning in 1920. Defining a
"scalper" as a firm that "typically buys and sells in large quantities,
expecting to hold the trade open only a very short time" and that
"intends to be even as to quantities bought and sold at the close of the
business day and is reluctant to carry a trade over night," the U.S.
government's 1920 definition of scalping tracks what today's high
frequency market maker firms say about themselves almost word for word.
While market makers in the futures markets have long fit the
government's definition of a scalper, in U.S. equities in the recent
past old-fashioned market makers carried inventory and committed capital
overnight -- even several nights -- to smooth buying and selling
pressures. They were required to post competitive quotes and to trade
sparingly in the exchange markets. No more. They don't exist. They were
too expensive and corruptible, and a series of well-intentioned reforms
squeezed or priced them out, unwittingly opening the door to scalpers
from the futures markets.
More than a few high frequency equities market maker firms today were
founded by "locals" (scalpers) from the futures markets, particularly
the Chicago futures markets. "Scalper" is not an endearment, so these
firms gussy up by calling themselves "liquidity providers" or "market
makers" or "principal traders" instead. The FTC observed the same in
1920, saying "There is a preference for designations that sound well.
Nobody calls himself a pit scalper." Though "liquidity provider" and
"market maker" are stripped of their former meaning in the equities
markets, high frequency firms wear these designations as if they were a
In his autopsy of e-mini SP 500 futures trading around the May 6,
2010 Flash Crash, Kirilenko describes how these firms destabilize
markets. There's a tipping point in volatile markets when, in an
instant, high frequency market makers stampede to rebalance their
inventories, even cascading positions from firm to firm, while prices
collapse. Kirilenko calls this "hot potato" trading, but it's an
interdealer panic, a market maker fratricide. His conclusions extend to
any volatile episode, because, as he wrote, high frequency market makers
"did not change their trading behavior during the Flash Crash."
Just as there were few restraints on the fund group whose selling
Kirilenko shows tipped the Flash Crash, there were few restraints on the
high frequency market maker algorithms that bought from it. Markets
crashed when high frequency market makers hit internal inventory limits
and unloaded onto the next market maker, which then hit limits and
unloaded onto the next one, and so on, driving the market down by almost
$1 trillion dollars in a few minutes.
Kirilenko studied e-mini trading in the futures market, but the CFTC
and U.S. Securities and Exchange Commission staff report on the Flash
Crash showed the same behavior at work in the equities markets,
doubtless from many of the same firms.
"Market Structure as a Joke"
The scalper's destabilizing practices are that it can quote as it
pleases and trade as aggressively as it pleases and still carry the
regulatory imprimatur and privileges of a market maker. As recently as
the late 1990s, little of this was true in the equities markets. As the
cash equities market automated, moved to decimals, deregulated and
fragmented in the last 10 years, scalpers moved in with a
soon-to-dominate business model, one they learned in the futures pits --
aggressive and often frenetic trading, keeping little or no inventory.
Instead of smoothing buy and sell pressures, as market makers in the
equities markets were -- in theory -- once supposed to do, scalpers
exacerbate or hide from volatility, as Kirilenko discovered in the Flash
Crash. The same was true in 1920, when the FTC noted that in volatile
markets scalpers "run with it, and they may accentuate an upward or
downward movement that is already considerable," or even, fearing
losses, that a scalper "closes out his trades when the market goes
against him, and this practice can but tend to accentuate the swing."
Registering as equities market makers, given valuable and unique
regulatory preferences and access, cozying up with exchanges desperate
for business, and then let loose on the stock markets, the scalper's
business model makes the stock markets structurally unstable. Scalpers
make the futures markets unstable too -- the FTC observed that scalpers
"themselves often create the volatility with which they are most
concerned" -- but their effect is especially pronounced in the equities
markets. Unlike the futures markets, prices in the stock market aren't
disciplined by prices in the spot market -- it is the spot market. And
unlike the futures pit markets, the public equities markets for the most
part trade in fixed price/time order, with no choice over
counterparties and no way to avoid scalpers who might turn to compete
for the very liquidity they just extended.
The stock and futures markets differ in other ways too, if only
because of the public confidence required of them. Whether the public
invests in stocks has much to do with its confidence in the stability
and integrity of the stock market. Whether the public buys orange juice
has little to do with its confidence in the stability and integrity of
the orange juice futures market. As important as the futures markets
are, they aren't forums for long-term, even generational capital
commitments, and the public doesn't directly invest its nest-eggs or
retirement savings in them. Companies don't rely on them to raise
capital for new plants, equipment and jobs.
After just the last few years of their relative dominance, these
firms have had extraordinary effects on the public equities markets.
Institutional volume is fleeing, while retail volume is skimmed off and
shrinks. Apart from liquid stocks, spreads have increased. Ominously,
exchanges are being co-opted, their traditional purpose recast as
technology providers, as simple hosts to a migrant group of high
frequency firms, and exchange markets, liquidity formation and price
discovery are fragmenting and uncoupling.
He might have had something else in mind, but we can take it as an
elegy to all of this when one senior stock exchange official was quoted
in the Financial Times as saying, "Most of the world views our market
structure as a joke."
A recent study found that high frequency firms post the best price at
least 50% of the time in the equities markets. The study's author and
high frequency firms pounced on this as strong evidence high frequency
firms contribute to price discovery, more so than any other kind of
The analysis and conclusion are superficial. A bid or offer has at
least four dimensions. Beyond price and size, any resting bid or offer
has a lifetime, and the inventory cycle or position resulting from any
executed bid or offer has a lifetime. Even if it's at the best price, a
bid or offer lasting a fraction of a second hasn't contributed to price
discovery, and market makers use the latest technology to post and
cancel thousands of bids and offers per second, even in the same stock.
An executed bid or offer where the position is unwound quickly and
aggressively isn't price discovery either. Kirilenko found high
frequency market maker inventory or position half-lives of less than two
minutes in the futures market. Some equities high frequency market
makers claim as little as 11 seconds in their stocks. Market maker
inventory cycles of a few seconds or minutes, enforced by aggressive
trading as time or prices go against the firm, actively destabilize
prices, especially so in already volatile markets.
Of a quote's four dimensions, only one has materially improved in the
last 10 years. Because of decimalization, automation and deregulation,
quoted spreads have improved for liquid stocks in stable markets. But
quote duration is down, time-in-inventory is down, and for many stocks
quote size is flat or down. This is all because, to manage costs, high
frequency market maker inventory cycles are engineered down to seconds,
and these firms keep their capital commitments low. High frequency firms
will tell you they're like any other business except that capital is
their inventory, and like any other business they make money by turning
over their inventory, so they churn it as fast as they can. Frenetic
trading isn't a byproduct of their strategies -- it is the strategy.
The effect of all of this is that investors looking at a quote today
can't predict what the quote means. They can't tell whether the quote
will be there when they submit an order against it, and they can't tell
when their own buying or selling will trigger a market maker's risk
threshold. If they do trigger a threshold, the market maker cartwheels
from liquidity supplier to liquidity demander to compete with an
investor's own liquidity needs. As it cartwheels, it can shock prices.
And when events align so market makers turn as a flock, as they did in
the Flash Crash, they can collapse the market.
This isn't price discovery. It's just short-term inventory management for unsupervised and risk averse scalpers.
Scalping dominates today because it's cheap, and because it's cheap
scalpers can post tighter spreads. It's cheap because the scalper's
liquidity is toxic. Its quotes are priced aggressively, showing tight
spreads, but only for small quantities with very short lifetimes, with
aggressive inventory management behind them to limit the firm's
exposure. Firms fine-tune their risk models to make their inventory
cycles as short as possible while preserving profits, lowering risk and
costs. And since current national market regulations focus mainly on
only one of a quote's four dimensions -- price -- if you're the best
price, by rule everyone must do business with you, and you gain market
Exchange-regulated firms with longer term inventory models couldn't
compete against the scalper's lower costs and tighter spreads, so over
the last 10 years exchanges deregulated and became hosts for the
scalpers, even cloning themselves to make new hosts. Deregulated, toxic
quotes flourished and crowded out more stable quotes. U.S. exchanges
today are interchangeable because scalpers determine market structure
through their increasingly toxic quotes. Rather than a diverse ecosystem
of market centers, with systemic resilience in that diversity, our
deregulated markets are inbreds relying on the same high frequency
market maker firms trading the same toxic scalper models.
As has been said, an insight from the Flash Crash is that "volume is
not liquidity." A further insight is that, batted about by scalper
inventory microcycles, published quotes don't represent genuine
liquidity either. A best bid today isn't a bid to own shares at a price,
or even a traditional dealer or market maker's attempt to provide
liquidity. As much as 50% of the time it's just a firm trying to scalp a
few basis points as quickly as possible. When that scalper's bid is
executed, it then becomes an unexploded competitive liquidity demand,
with the timer set, as Kirilenko found, at about two minutes, or even
less. These destabilizing trade practices are a fundamental structural
instability behind the Flash Crash.
At the November 5, 2010 meeting of the Joint CFTC-SEC Joint Advisory
Committee on Emerging Regulatory Issues, former SEC Chairman David Ruder
wondered whether to increase costs for high frequency market makers. He
didn't suggest taxing them, as with a transaction tax. He asked whether
they should face affirmative quoting obligations, "whether there should
be some requirements that they provide liquidity." But along with
affirmative quoting obligations, they should also face negative
obligations, once common regulations limiting their ability to
exacerbate price movements. Without negative obligations, affirmative
quoting obligations make quotes still more toxic -- firms required to
provide liquidity will trade even more aggressively to manage inventory.
Negative obligations will prevent scalper fratricides, and stop high
frequency market maker firms from unloading inventory onto the firms
behind them. Without that kind of "hot potato" trading, the volume
sensitive algorithm that tipped into the Flash Crash would not have
descended into a lethal feedback loop as it traded against cart wheeling
toxic quotes. The simplest negative obligations will extend market
maker inventory cycles, preventing these firms from flipping into a
liquidity crisis, as they did in the Flash Crash.
In the equities markets, inventory microcycles are another reason to
restore the public's priority at a price. The public's orders used to
trade first at a price because professionals had time, place and
information advantages over the public, but that regulation was
eliminated as the exchanges deregulated. Professionals still have these
advantages over the public, and today they are for sale to as many
professionals as can afford them. Apart from questions of access and
fairness, a frequently overlooked structural advantage of public
priority is that the public's inventory cycle is longer than that of
market makers. Restoring the public's priority in price queues both
limits the reach of unexploded liquidity demands and recognizes the
public's many disadvantages to professional scalpers.
The equity market reforms and deregulation of the last 10 to 15 years
happened for good reasons -- monopoly profits were flowing to
intermediaries and exchanges, intermediaries were taking advantage of
their customers, innovation was being strangled by entrenched interests
-- and it was time for reform. As many of us hoped, new participants,
technology and business models sprang up. Nobody wants to undo that
progress. By analyzing trade and position data from the futures market,
Kirilenko's breakthrough was to show how a dominant class of these
business models can be disruptive, and how these models can be
destabilizing enough to create systemic risk as an inherent consequence
of their design. On a gross basis, these models can be checked by
circuit breakers or price limits, and this is one reason price limits
are standard in the futures markets. In the equities markets, these
models must be checked even before they trigger circuit breakers or
price limits because the equities markets are profoundly different from
the futures markets. The simplest way to check these models is to put
reasonable restraints and obligations on them.
A basic function of any market is to produce a quote. The scalper's
toxic quotes, thousands of them a second, are a hoax on our equities
markets. No one planned it. It happened as an unanticipated consequence
of well-meaning reforms to a flawed system. There is no competitive
solution to this problem within current regulations so long as quote
price is a routing table's first regulatory imperative. Competition
simply forces exchanges to publish more and faster toxic quotes, as
market power continues to shift from the exchanges to the scalpers.
Finally, some have pointed out that regulation didn't work in the
market break of 1987, when old-fashioned specialists and market makers
shirked their responsibilities and hid from the market, and regulation
won't work today. Regulation didn't stop them from shirking their
responsibilities, but regulation didn't excuse them either, and
regulation didn't encourage them to automate a deadlier game than
hide-and-seek -- intermediaries didn't exacerbate the 1987 market break
by playing market maker "hot potato," a feat unique to the Flash Crash.
And the logic of "regulation didn't prevent 1987, so regulation won't
work" is a civic novelty. Should we apply that logic to drunk driving,
or to any other misbehavior?
Of course not. Please regulate them.
R. T. Leuchtkafer
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